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A Surprising Opportunity In Europe For Some Investors

OCEAN CITY — In today’s low interest-rate environment, the search for higher-quality, higher-yield fixed income can sometimes seem like a fantasy. While low-risk standbys such as 10-year U.S. Treasury bonds and 10-year German bunds offer principal protection at their current yields of 1.8% and 1.5%, respectively, barely beat current inflation. Recently, bonds issued by some European countries offer more attractive yields, but considering the serious economic problems the Eurozone continues to face, it’s important to note that they often carry much higher risks than relatively steadier options.

There is, however, an alternative that can offer attractive yields as well as lower risks: European supranational bonds, which are issued by organizations owned and capitalized by multiple European nations—entities such as the European Investment Bank (EIB), the Council of Europe Development Bank (CEB) and the European Bank for Reconstruction and Development (EBRD). The groups issue debt denominated in U.S. dollars as well as euros and other currencies to support everything from Eurozone recovery efforts to lending by local and regional European banks.

"During the past few years, supranationals have been hit by fears of a Eurozone breakup," says Ralph Axel, a bond analyst at BofA Merrill Lynch Global Research. Those worries, he notes, have kept the prices of supranational bonds down and their yields up—despite a generally low risk that the bond issuer will fail to meet their obligations.

Indeed, the market frequently paints supranational organizations with the same brush as the individual European nations issuing sovereign debt. But supranationals hold assets from across the Eurozone, thereby diversifying risk. Although the advantage of supranational bonds over Treasuries has narrowed in recent months, many of these investment vehicles may potentially still provide solid income combined with high quality, and can in turn add diversification to a fixed income portfolio, Axel says.

Despite the relatively high quality of supranational bonds as a whole, there are significant differences among issuers—including differences in the guarantees they offer and in the risks each organization carries on its balance sheet. "These issuers are not all the same, and it’s not enough just to look at the credit rating," says Ralf Preusser, head of European rates research at BofA Merrill Lynch Global Research. Preusser emphasizes the importance of doing an analysis of individual issuers before buying supranational bonds.

Fortunately, the information is readily available. Most supranationals offer easy-access online resources and investor-relations managers who are available by phone. Factors to consider include an organization’s relative level of exposure to the Eurozone’s ongoing sovereign debt crisis, the group’s track record on defaulted loans and its vulnerability to major, unforeseen crises.

With respect to the third factor, consider how the EIB and the CEB might fare if, in a worst-case scenario, the Eurozone collapsed. The EIB is owned by individual countries that will likely continue to exist regardless of the Eurozone’s fate. Accordingly, EIB bond prices could experience plenty of volatility if the Eurozone went under, but the risk of actual default would be relatively low. The European Commission, however, issues debt on behalf of the European Union itself. As such, it would be much more likely to default on its obligations were the Eurozone to dissolve.

(A Merrill Lynch senior financial advisor who can be reached at 410-213-8520.)